The U.S. Border Tax and Its Implications for the EU

In summer 2016 the Republican majority of the U.S. House of Representatives unveiled its plan to launch the biggest tax reform effort in more than 30 years. The blueprint’s core elements are income tax cuts; a low, nonrecurring tax on undistributed foreign earnings; and a fundamental reform of business taxation. The plans for the last item are revolutionary in that House Republicans do not seek only to reduce the corporate tax rate to 20 percent; they also want to convert the classical system of business taxation to a destination-based cash flow tax (DBCFT) with a border tax adjustment.¹

Globally implemented, the DBCFT system would solve almost all problems that haunt the international tax system: tax-induced production relocation and profit shifting and inefficient incentives to take up debt instead of equity. After a transitional phase, all those inefficiencies would be things of the past. However, U.S. House Republicans are not pushing for global implementation, but for unilateral introduction in the United States. That has several substantial implications, especially for U.S. trading partners in the EU.

The good news for Europe is that the United States’ European trading partners would not lose across the board. European companies with U.S. subsidiaries might even benefit from a switch to the DBCFT overseas. European exporters, however, might suffer from an increased EU tax liability, which would benefit European governments.

Perhaps surprisingly, given the strong Republican focus on supporting the U.S. economy, U.S. companies with subsidiaries abroad could be harmed by the new tax. Therefore, the claim that countries would have an incentive to adopt the DBCFT “either to gain a competitive advantage over countries with a conventional origin-based tax, or to avoid a competitive disadvantage”² must be qualified. Finally, tax competition between the United States and the EU could become much more severe because of heightened incentives to shift the tax base (via either transfer pricing or relocation of intellectual property or real production) to the United States.

The Theory Behind the DBCFT

The dominating principle in international business taxation is the source country principle; in that sense, business tax systems are territorial systems. Business profits are taxed at their source — that is, where they are generated, as indicated by the location of production or value added. For companies with more than one production location, transfer prices are required to determine locational profit. The U.S. business tax regime is aligned with that model, even though the United States purportedly places stronger emphasis on residence taxation than its trading partners do. For decades, U.S. multinational enterprises have been able to largely avoid taxation of foreign source earnings by accruing profits in overseas subsidiaries or by inversions.

In contrast, the DBCFT emphasizes the destination country principle, known for the VAT or the goods and services tax (GST). The underlying idea is that international mobility of consumers is low and cannot be manipulated by the taxed companies. To that effect, the House plan for a DBCFT implies a border tax adjustment. Revenues from exports are tax exempt, whereas import revenues are fully taxable.³ The production cost (especially payroll) is deductible from the tax base where the costs are incurred — that is, where either the inputs have been subject to DBCFT themselves or, for labor supply, where the employee performed the work and was subject to payroll tax. A similar border tax adjustment is common with a VAT, the difference being that the DBCFT allows for the deduction of both received inputs and labor costs. An export company would therefore have a negative tax base in the domestic country because its revenues would be tax exempt and its cost would be deductible, but its revenues would be fully taxed by the destination country.

Other important changes from the current system are the cash flow tax and the treatment of financial flows. The DBCFT exempts the normal return to capital from tax and prevents tax discrimination between different sources of financing (for example, debt and equity).⁴ The overall effect is a smaller tax base, which might lead to reduced tax revenue. Moreover, revenue implications might temporarily arise depending on whether a country is a net importer or exporter. The tax base under a DBCFT can be expressed as the domestic value added plus the difference of imports and exports. That difference is zero across all companies if the trade balance is even. Because that result is to be expected in the long run,⁵ revenue implications mainly come from the switch to a cash flow system. That does not rule out the possibility of substantial short-term revenue effects.

If DBCFT implementation were internationally coordinated, the tax could be completely neutral for business location and investment decisions because it can be understood as a combination of two elements.⁶ The first is a classical VAT element, in which exports are tax exempt but imports are fully taxed (trade remains undistorted).⁷ The second is a subsidy for domestic wage payments that results from the deductibility of all domestic payroll. Because the subsidy is granted to all domestic companies, the resulting surge in labor demand leads to a one-by-one wage increase. In the end, net-of-tax production costs stay constant.⁸ Thus, the subsidy is completely neutral for trade (ignoring potential redistributive effects in the tax system). To sum up, net wage costs are unaffected by the tax system and revenues are taxed without regard for the location of production.⁹

The DBCFT’s neutrality depends on sufficient flexibility in the general price level or exchange rates.¹⁰ While that assumption seems reasonable in the medium to long term, there could be substantial deviations in the short term.¹¹ There has also been debate on whether a substantial exchange rate or price level movement, as predicted by DBCFT proponents, is to be expected.¹² For the sake of argument, we will stick to that assumption.

Effects of Unilateral Introduction

The U.S. House has proposed unilateral introduction of the DBCFT. The ensuing coexistence of DBCF and source-based tax systems such as those in the EU could give rise to numerous problems. That is no surprise, given that the DBCFT as envisaged is essentially equivalent to introducing a subtraction-type VAT with corresponding tax relief for wage earners, while still formally maintaining the guise of classic income taxation.

From an economic perspective, the conversion to a DBCFT would eliminate the classical Haig-Simons type of business taxation and transform the United States into a tax haven. That has severe implications for companies’ incentives to avoid taxes, which is why that kind of reform has been labeled the “ultimate move in a tax competition game.”¹³ Moreover, the interaction of classical systems and the DBCFT could have substantial effects on companies’ effective tax rates.

Legally, the DBCFT might still have to be classified as some category of business income or corporate tax. That could cause complications in the tax systems of U.S. trading partners, particularly for the size of the tax base in EU systems. At the same time, it makes the proposed reform vulnerable to claims that it violates U.S. tax treaty and world trade law obligations. Finally, the uncoordinated introduction of a DBCFT could have considerable distortive effects on international trade and discrete investment choices during transition.

Implications for Tax Competition

The conversion of classical business taxation into a DBCFT would cause a stark increase in companies’ incentives to shift their tax bases (by transfer price manipulation or asset relocation) to the United States. As noted, under a DBCFT, the U.S. tax liability is independent of the location of production and assets. By contrast, EU tax liability depends on the allocation of taxable income across company locations through the location of assets and real economic activity, as well as intra-company transfer prices. That asymmetry creates strong incentives to locate taxable income in the United States for tax-saving purposes by reducing EU tax liability without increasing U.S. tax payments.¹⁴

To be specific, with U.S. tax liability becoming independent of transfer prices, the incentives to manipulate transfer prices or shift assets and production are the same as with a zero-rate tax haven. For instance, a German multinational company would save around €0.30 for each euro shifted to the United States. The same is true for European exporters that might find incentives to open affiliates in the U.S. to avoid the tax surcharges in the EU triggered by the DBCFT introduction.

A DBCFT would thus generate substantial gravitational power on book profits, asset location, and real production from the EU. For discrete investment decisions, that effect would likely be further aggravated by the temporary impact the introduction of a border tax adjustment would have on the cost of imports. Those goods will become substantially more expensive than competing domestic products and services during a transition period, because they would be taxed on a gross basis until nominal exchange rates or domestic price levels adapt and neutralize the initial competitive disadvantage. European multinationals that already have U.S. production sites seem to be prepared to expand those sites significantly if the House blueprint is adopted.¹⁵ Those immediate effects on the location of real production would not be easily reversed, even if rising effective exchange rates would eventually compensate for the gross taxation of imports.

International Public Law Implications

The border tax adjustment associated with the introduction of a DBCFT has frequently been considered incompatible with WTO law. Some scholars and experts say the tax exemption for exports is to be classified as a prohibited export subsidy under Article XVI of the General Agreement on Tariffs and Trade, and article 3.1(a) of the Agreement on Subsidies and Countervailing Measures (ASCM). They also consider the denial of a tax deduction for foreign-source wage costs when levying DBCFT on imported goods an infringement of the national treatment requirement in GATT Article III:2 or III:4. In a similar vein, the import taxation of services on a gross basis would amount to a violation of Article XVII of the General Agreement on Trade in Services (GATS) if the adopting country has committed to national treatment of services, too.¹⁶ That assessment usually rests on an early, though nonbinding, GATT report,¹⁷ as well as on the legally binding explanations to GATT Article XVI and ASCM article 1.1(a)(1)(ii), under which a border tax adjustment is permissible only for indirect taxes, and for VAT in particular. In contrast, border tax adjustments that seek to implement the destination principle for direct tax purposes contradict WTO rules.

In our opinion, the DBCFT is not necessarily in conflict with WTO law — at least not once modifications to the House blueprint were introduced. First, the test for forbidden export subsidies differs from the assessment of the national treatment requirement regarding imports. According to consistent interpretation of ASCM article 1.1(a)(1)(ii), a fiscal stimulus effect cannot be regarded as a (potentially) forbidden export subsidy if it results from consistent implementation of the guiding principles of the tax system in question.¹⁸ The exemption of export revenues is a coherent and integral part of the proposed DBCFT that chimes with the idea of taxing consumption where it presumably occurs,¹⁹ because it is long-established and generally accepted in the realm of VAT.²⁰ Therefore, it does not amount to a subsidy under ASCM article 1.1(a)(1)(ii).²¹

In comparison, the obligation to give national treatment to imports has been interpreted more strictly, in the fashion of a nondiscrimination principle by the WTO’s adjudication bodies.²² As a consequence, distortions of competition to the detriment of imports that arise from the tax system of the importing country could infringe GATT Article III or GATS Article XVII, regardless of whether they originate from conceptually essential elements of the tax system or from special measures that do not correspond with the system’s internal logic.²³ Against that background, the DBCFT in the House Republicans’ reform proposal would likely have to be classified as an internal tax regime that discriminates against imports by according less favorable treatment to them than to competing domestic products and services.²⁴

However, those WTO law concerns could be overcome without substantial changes by converting the deduction for local wage costs into an equivalent, free-floating tax credit that could be used to reduce the liability for any federal U.S. tax. The DBCFT would then be formally deconstructed into its constituent elements: a subtraction-type VAT and relief for local labor input. Each element of the reform would then have to be assessed in isolation under GATT Article III and GATS Article XVII. Border tax adjustments are generally accepted for a VAT, the abolition of traditional business taxation is also admissible, and general wage subsidies for local labor input cannot in themselves be regarded as favorable treatment “accorded to products” under GATT Article III:4. With that kind of modification, the proposal should pass WTO scrutiny.

In any event, it cannot be taken for granted that the U.S. Congress or the Trump administration will let themselves be constrained by global trade rules. The determination of a legal breach takes time and would likely involve several rounds of assessment. Even if incompatibility with WTO requirements were confirmed, the result would not be an enforceable ultimatum to repeal the new rules. Instead, it would merely give U.S. trading partners the right to apply countervailing measures as sanctions and penalties.²⁵

Finally, the proposed DBCFT would likely contravene many U.S. tax treaties. Although its focus on cash flows makes the DBCFT effectively a consumption tax — and that conversion is further enhanced by the destination principle — it would probably still be regarded as an income tax under article 2 of the OECD model convention and the tax treaties that follow that model. Because the revenue allocation rules in the OECD model are still firmly based on the concepts of source and residence, taxing imports based on gross revenues and without sufficient territorial nexus regarding their production would contravene U.S. treaty obligations.²⁶

Effects on Profits and Tax Revenues

For multinational companies with establishments involved in the value chain in both the United States and in the EU that are therefore taxed in both economies, the unilateral introduction of the DBCFT would likely affect their competitiveness even after adjustments to the effective exchange rate. That is because the adjustment (in the nominal exchange rate or the general price level) necessary to compensate for the introduction of a DBCFT and restore the prior trade equilibrium depends on a company’s share of value added in the United States. However, there is only one adjustment that can actually take place. In a scenario in which a homogeneous good is traded at zero cost and consumed in both economies, arbitrage opportunities imply that the price level or exchange rate adjustment must correspond exactly with the DBCFT rate — that is, be equal to a factor of 1/(1-DBCFT).²⁷ Otherwise, goods could be shipped cross-border at a profit. Thus, U.S. MNEs with taxable income in the EU suffer because their foreign income is depreciated too much, and European MNEs with positive tax bases in the United States gain because their foreign income is appreciated too much.²⁸ To see that, consider the following simple example.²⁹

As a consequence, unilateral U.S. introduction of a DBCFT would shift the burden of U.S. business taxation from European to U.S. multinationals — a tax effect that is in odd contradiction to President Trump’s “America First!” rhetoric. Under source-based taxation, part of a U.S. MNE’s income is shielded from U.S. taxation under transfer pricing arrangements, but the DBCFT reduces the company’s profits through general equilibrium effects to an extent equivalent to the full taxation of its overseas sales after European profit taxes.³³ In that sense, the DBCFT imitates worldwide taxation after deduction of foreign taxes.³⁴ Being taxed at an effectively higher rate would reduce the competitive position of the average U.S. multinational vis-à-vis domestic companies in European or other markets.

Similarly, European multinationals benefit because the price or exchange rate adjustment overcompensates them for the tax burdens resulting from the implementation of the DBCFT. Compared with the situation before DBCFT, the European company in the example saves €5, which corresponds to the saved pre-reform U.S. tax. Because those companies can offer their goods at a lower tax-inclusive cost, the DBCFT provides them with a competitive advantage over U.S. companies on the U.S. market.

DBCFT Effects on the European Tax Base

Finally, unilateral U.S. introduction of the DBCFT could affect the size of the European part of a company’s taxable income. That can be illustrated with EU-based pure exporters, which are currently assumed to have no taxable income allocable to the United States. The gross revenues (in euros) are appreciated (either as a result of U.S. inflation or appreciation of the dollar). That appreciation fully compensates the company for the U.S. tax payment. However, if gross revenues enter the tax base in the EU country, the exporter’s EU tax liability increases even though its income (before European tax payments) stays constant. The degree of that surcharge depends on both the European and DBCFT rates because the DBCFT rate drives the size of the dollar appreciation. Thus, exporting companies from high-tax locations in the EU could suffer from a tax disadvantage as a result of the DBCFT’s introduction. The additional tax payments are collected by the EU country under consideration, which in turn benefits from the DBCFT.

The overtaxation of EU exporters could be neutralized by taxing total revenues net of DBCFT. Technically, that would imply a deduction from the European tax base of taxes paid in the United States. It is far from certain that such a deduction or even a DBCFT credit will be granted. A credit in particular would routinely be denied by EU member states on grounds that levying DBCFT on imports lacks a legitimate nexus for taxation of corporate profits. A deduction from the tax base might be granted in some EU jurisdictions but not in others, depending on whether the DBCFT would be regarded as a tax on income or as a tax on (specific forms of) consumption.³⁵

Possible EU Reactions

It is unclear whether and to what extent the U.S. Congress and Trump will endorse a DBCFT with border tax adjustment as part of a tax reform package. Leading House Republicans are apparently still committed to the concept, which was recently declared a “given” by Rep. Kevin Brady, R-Texas, chair of the House Ways and Means Committee. The Trump administration has shown an ambiguous attitude toward the proposal, however, with the president’s closest advisers seemingly divided on the border tax adjustment. It is possible that Treasury Secretary Steve Mnuchin will come out with a less ambitious plan that focuses on reductions in rates to avoid yet another split among congressional Republicans following the healthcare debacle. That might be an even more attractive option, given that the transition to a DBCFT raises not only fundamental questions, but also intricate, technical ones.³⁶ On the other hand, the border tax adjustment would currently generate significant tax revenues and thus partially compensate for rate reductions, and the concept of taxing imports and exempting exports sits well with Trump’s economic agenda. A compromise might consist of a staged implementation, by, for example, first introducing a “small” DBCFT of maybe 10 percent while maintaining classical business taxation at lower rates.

Because a clear-cut prediction is impossible, it seems reasonable for the EU and its member states to prepare for a possible U.S. DBCFT scenario. The European Commission has announced that it will file a WTO complaint should the border tax adjustment be adopted as part of a U.S. corporate tax reform, which it has already begun drafting. However, for the reasons discussed, that is hardly a promising reaction because it would not have any short-term effect and could eventually lead to a costly trade war. The EU also should not count on the OECD to push for retraction of the DBCFT concept, even though it is at odds with the traditional system of international taxation the organization promotes and recently overhauled as part of its base erosion and profit-shifting initiative. Considering that the United States is the OECD’s most important member, it is more likely that the organization would jump on the bandwagon and attempt to moderate any transition to maintain its clout as the leading institution on international tax policy.

Instead, should the DBCFT take effect, EU member states will have to adapt their tax systems at both the national and EU levels. As demonstrated, the primary concern of any adjustments should not be the purportedly long-term competitive disadvantages for the European export sector and European investors. Any short-term protectionist effects of the border tax adjustment could be expected to be neutralized relatively soon through counterbalancing nominal exchange rate or price effects. Instead, the real concern should be the gravitational power of a U.S. DBCFT on book profits, asset location, and real production. Implementing the BEPS outcomes and the corresponding EU anti-tax-avoidance directive (EU/2016/1164) will be insufficient, especially because those measures are not intended to curb international tax competition over real investments. In principle, the EU and its member states would be free to follow the United States in implementing the DBCFT. However, such a fundamental shift would be highly unlikely to happen in the short term or in a coordinated approach endorsed by all 27 EU member states.

Because the aforementioned effects of full or partial replacement of classical business taxation with a DBCFT would be felt almost immediately, EU lawmakers would probably have to resort to interim solutions first to avoid irreversible losses of tax revenue and investments, and then consider more fundamental reform options.

In the short term, it might be wise to adopt temporary measures to avoid competitive disadvantages for the exporting sector, particularly in countries with significant exports into the United States, such as Germany.³⁷ For pure exporters in particular, distortions could be alleviated by making DBCFT payments in the United States deductible from the tax base of classical European corporate taxes. If made permanent, that measure would ensure that a level playing field for exporters would be fully restored after an adjustment of the effective exchange rate. On the downside, the tendency of the DBCFT to undertax European MNEs would then be aggravated — and in any event, that kind of measure is initially very costly in terms of forgone revenue. Additional short-term measures might consist of tightening the rules on exit taxation and the transfer pricing adjustments of business restructurings to avoid an immediate exodus of production activities to the United States, especially with a view toward multinationals that already operate production sites there. The incentive to relocate IP to the United States, which would be a tax haven, could be mitigated by introducing or expanding patent box regimes.

In the long term, the EU and its members could find themselves economically forced to embrace the DBCFT concept as a benchmark for European tax systems, and to at least mimic its core features if outright adoption is not politically feasible.³⁸ Given the similarities between the DBCFT and a broad-based, single-rate VAT cum wage cost deduction, a gradual transition would be possible, thereby at least temporarily maintaining the classical tax mix. To that effect, it would be necessary to lower the level of the traditional corporate or business tax in place, possibly combined with an allowance for corporate equity for immediate attainment of marginal investment neutrality.

Simultaneously, and to compensate for the ensuing revenue loss, the VAT revenue would have to be increased, primarily by abolishing exemptions and reduced rates. The result would be the emulation of a DBCFT that is also compatible with world trade law and tax treaty obligations. There could ultimately be full-fledged adoption of the tax and abandonment of the traditional coexistence of business taxation and VAT. Should the United States settle for a small DBCFT solution and maintain a substantially reduced classical business tax, this long-term move might not even be necessary. Even so, it could still be an attractive reform option for some EU member countries.

Finally, to alleviate the distributional effects of a shift from taxation of business profits toward the increased role of a VAT, an amount based on the product of local wage cost and the increase in the effective VAT rate could be credited against the business tax liability, social security contributions, or payroll taxes, which would move the system even closer to the DBCFT concept.³⁹

If measures for a gradual transition fail to neutralize the “force of attraction” of a future U.S. DBCFT on book profits, IP, and investments, EU member states will also have to rely on a carrot-and-stick approach. That could involve an array of antiavoidance and anti-BEPS rules, such as royalty deduction barriers, strict transfer pricing adjustment rules, and improved rules for controlled foreign corporations. On the incentive side, special regimes for research and development expenditures and an allowance for the standard return on equity could prove effective. In fact, those incentives have already been proposed by the European Commission in its initiative for a common consolidated corporate tax base.⁴⁰ Some of the measures contemplated above might require EU legislation to overcome concerns regarding their compatibility with EU tax legislation, EU fundamental freedoms, or EU state aid rules.